I often find that the single largest asset my baby boomer clients have is in the form of an IRA or 401(k). When that’s the case, I always counsel my clients about the importance of properly listing the beneficiaries on those accounts so that their estate plan operates the way they want it to. Typically, baby boomers name their spouse as the sole beneficiary of their retirement accounts. When the account owner dies, the surviving spouse has favorable tax laws and a lot of flexibility to decide what happens to their inherited IRA, including rolling it into their own. However, what does a single or widowed person do with their IRA when they die? 

Non-Spouse Inherited IRAs: A Lesson in Asset Protection

When your children (or any other non-spouse beneficiaries) are listed as beneficiaries of your retirement account and they inherit it outright, you might be exposing your account to your children’s creditors. The US Supreme Court recently held that creditors can attach their claims to any non-spouse inherited IRA. For example, when the beneficiary of an IRA is not the surviving spouse, the Federal Bankruptcy Act does not protect the IRA during bankruptcy if it is in the form of an inherited IRA. Furthermore, when a child beneficiary goes through a divorce, the divorcing spouse may be able to attach a right to your child’s inherited IRA. In addition, a person your child injured in a car accident may also be able to attach a right to the inherited IRA. If you are concerned about exposing your retirement accounts to your children’s creditors, divorcing spouse or in bankruptcy, it may be in your best interests to name a Retirement Beneficiary Trust as the beneficiary of your largest asset instead of your children individually.

What is a Retirement Beneficiary Trust?

Also known as a Standalone IRA Trust or an IRA Inheritance Trust, a Retirement Beneficiary Trust is an estate planning tool that controls the distribution of your retirement accounts to your loved ones upon your death. It provides a level of asset protection for your children that they otherwise cannot attain when inheriting your IRA outright. An added benefit to the Retirement Beneficiary Trust is that the trust can mandate your children to “stretch out” their inherited IRA’s required minimum distributions (RMDs) rather than cash out the IRA completely. The longer the IRA distributions can be stretched out over a child’s lifetime, the more wealth is transferred to the child over time. If a child were to cash out the IRA or if they had to use an older beneficiary’s life expectancy, that child would be subject to larger income tax payments and would be given a greater opportunity to recklessly spend the money or poorly invest it. 

How does a Retirement Beneficiary Trust Work? Conduit v. Accumulation Trusts

To properly establish a Retirement Beneficiary Trust, four basic requirements must be met:

  1. The trust must be valid under state law

  2. The trust must be irrevocable or become irrevocable upon the grantor’s death

  3. The beneficiaries must be identifiable from the trust agreement

  4. The plan administrator is provided documentation of the trust

The Retirement Beneficiary Trust will also be one of two types of trusts: a conduit trust or an accumulation trust.

A conduit trust receives the RMDs from the IRA and then distributes those RMDs to the trust beneficiary. This type of trust does not accumulate and hold excess IRA distributions in trust like an accumulation trust. As a result, a conduit trust does not provide much asset protection for the trust beneficiary because a creditor can simply attach to the RMDs when they are distributed from the trust to the beneficiaries. However, the advantage to having a conduit trust is that the beneficiaries are easily identifiable (requirement 3, above). The beneficiaries must be identifiable because the IRS uses this information to determine the RMDs for the inherited IRA using the oldest beneficiary’s life expectancy. If an older beneficiary’s life expectancy is used, the “stretch out” will not be maximized to its fullest potential. A conduit trust easily prevents this situation because it is not holding assets in trust and does not have unintended contingent beneficiaries.

On the other hand, an accumulation trust allows IRA distributions to be accumulated in the trust and distributed to the beneficiaries under the terms of the trust. This allows greater asset protection; however, under an accumulation trust, the IRS will consider the life expectancies of all remainder and contingent beneficiaries when determining the RMD amounts for the inherited IRA. For example, if there is some unintentional contingent beneficiary who is 85-years-old, that person’s life expectancy will be used for income tax purposes and it will minimize the “stretch out” for the intended younger trust beneficiaries. Accumulation trusts can be more complicated than conduit trusts because the drafting attorney must consider every contingency in the trust to prevent the IRS from identifying older contingent beneficiaries.

Drafting Retirement Beneficiary Trusts, especially accumulation trusts, requires advanced tax law knowledge. If you have concerns with asset protection and whether or not your children will maximize their stretch IRA, a Retirement Beneficiary Trust might be right for you. Meet with your attorney, CPA, and financial advisor to learn more about Retirement Beneficiary Trusts.

Bill Hesch is a CPA, PFS (Personal Financial Specialist), and attorney licensed in Ohio and Kentucky who helps clients with their financial and estate planning. He also practices elder law, corporate law, Medicaid planning, tax law, and probate in the Greater Cincinnati and Northern Kentucky areas. His practice area includes Hamilton, Butler, Warren and Clermont counties in Ohio, and Campbell, Kenton and Boone counties in Kentucky.

(Legal Disclaimer: Bill Hesch submits this blog to provide general information about the firm and its services. Information in this blog is not intended as legal advice, and any person receiving information on this page should not act on it without consulting professional legal counsel. While at times Bill Hesch may render an opinion, Bill Hesch does not offer legal advice through this blog. Bill Hesch does not enter into an attorney-client relationship with any online reader via online contact.)